What is Undercapitalization?

Undercapitalization is a condition that involves an inability to fund a business venture sufficiently. Essentially, the amount of generated revenue and other resources in the control of the business are not enough to cover the ongoing operating costs associated with the venture. When a corporation lacks capital to sustain production at a profitable level, the business is in immediate danger of bankruptcy and possibly dissolution.

There are several situations that can lead to an undercapitalized state for a company. When changes in consumer habits render the most profitable products manufactured by the corporation undesirable, the dwindling sales may not be enough to offset the costs of operation. In order to correct the state of undercapitalization, the company will need to either curtail production of the obsolete products to service a smaller market, or develop new products that will be able to attract the attention of a new consumer market.

A second scenario that may develop into a lack of sufficient capital involves a start up company. Generally, a new company will attempt to secure backing that provides resources to cover operational costs until the company can begin to generate revenue and make a profit. When the new company fails to attract enough business to meet the production costs within the projected time frame, the venture will be considered undercapitalized. At this juncture, investors can choose to invest additional resources into the company or cut the losses and pull out of the business.

Many companies will experience at least one phase of undercapitalization at one time or another. Often, the lack of funding capital often is on the front end, while the business is still building a viable client base. Unless the business plan contains accurate projections about how much funding is needed to support the business until profitability is reached, a temporary period of undercapitalization will occur.

At other times, changes in consumer tastes or advances in technology will trigger a period in which the company must adapt in order to remain profitable. During this transition, the company may need to seek outside assistance in order to make the adjustments needed to remain a viable entity, or at least cash in assets that are not essential to the base operation in order to keep going. Without correction of this state of undercapitalization, the business will not make it through this transitory period and will eventually fail.